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The financial markets have taken the world economy hostage. This has presented the world’s central banks with a dilemma. They fear the consequences of paying off those responsible for the mess. But they cannot let hundreds of millions of innocents suffer. Last week’s announcement of the first US monthly fall in employment for four years has made a cut in interest rates from the Federal Reserve this month a virtual certainty. So act it will. But making the right decisions is going to be hard.

Martin Feldstein of Harvard university put the case for big cuts in a powerful summing up at this year’s Jackson Hole monetary conference.* He argued that the US housing sector was at the heart of three interrelated events. First was “a sharp decline in house prices and the related fall in home-building that could lead to an economy-wide recession”. Second was “a subprime mortgage problem that has triggered a substantial widening of all credit spreads and the freezing of much of the credit markets”. The third was “a decline in home equity loans and mortgage refinancing that could cause greater declines in consumer spending”.

Prof Feldstein pointed, for example, to a 3.4 per cent year-on-year decline in US house prices, with the chance of substantially more to come. Robert Shiller of Yale argued at the same conference that US house prices might ultimately fall by as much as 50 per cent, which would lower US household wealth by more than $10,000bn.

Prof Feldstein also noted the damage done to the financial markets by the crisis in subprime lending. This is partly because credit spreads are correcting, albeit modestly so far. More important, “as credit spreads widened, investors and lenders became concerned that they did not know how to value complex risky assets”. With confidence gone, banks have been forced to advance loans to their off-balance-sheet “special investment vehicles”, which uses up their capital and so starves other borrowers.

Finally, as house prices and borrowing fall, household saving rates will rise towards more normal levels and residential investment fall still further. This combination seems sure to generate a rapid decline in the personal sector’s financial deficit (discussed in my column of August 21 2007).

Prof Feldstein concluded by recommending a “risk-based approach”, which treats the risk of a recession as more important than that of an upsurge in inflation. If the latter were indeed to happen, “the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it would succeed in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability.”

If the Fed did what Prof Feldstein recommends, it would risk undermining its credibility. How, then, did it get into this mess? At Jackson Hole, John Taylor of Stanford university – inventor of the “Taylor rule” (which relates monetary policy to movement in output and inflation) – blamed the Fed for excessively loose policy between 2002 and 2006.

Thus, Prof Taylor believes the Fed made a mistake under Alan Greenspan’s leadership. Prof Feldstein suggests it should risk repeating it. But these distinguished academics and, indeed, most of the US academic discussion ignore the international dimension to both the origin and resolution of this turmoil.

Prof Taylor dismisses the “savings-glut” explanation for the low US interest rates, with the observation that global savings rates are lower than three decades ago. But the world, without the US, had a rapidly rising excess of savings over investment in the early 2000s, much of it directed to the US. Given the huge capital inflow, the Fed’s monetary policy had to generate a level of demand well above potential output.

The international dimension also shapes the resolution of the crisis. The Fed has a delicate judgment to make, not just between saving the hostages and rewarding the hostage-takers, but also between saving the US economy and risking confidence in the dollar.

In essence, the dollar needs to weaken, but not to crash. The Fed cannot risk a big rise in long-term interest rates, in response to loss of confidence in US price stability and an exchange-rate collapse.

Yet when house prices are expected to fall, lower interest rates themselves are unlikely to persuade people to borrow and spend. Thus a large part of the impact of lower interest rates must come via a weaker dollar and large improvements in the external balance.

This is another way of saying that the era in which the world could rely on the engine of US consumption is now at an end. If anything, the engine is more likely to go into reverse.

So the long-awaited and much-discussed “rebalancing” of the world economy is about to accelerate. Should the rest of the world fail to respond appropriately, a significant global slowdown is foreseeable.

Yet the US is not the only country in such a predicament. In an era of low interest rates, house prices soared in a number of developed countries. These also are vulnerable to a house price correction.

Much of the adjustment to lower growth, or even a decline, in US consumption must come elsewhere. Among others, China will be in the eye of this storm. Suppose, for example, that the dollar went down against the floating currencies, notably the euro, accompanied by the renminbi. Suppose, too, that the Chinese authorities took no measures to expand domestic demand. Then the external adjustment would fall elsewhere in the world. This would prove highly disruptive, particularly in continental Europe. Even the commitment to open markets might be endangered.

The combination of house price falls with a financial crisis in the core country of the world economy means big challenges for policymakers everywhere, particularly for the Fed, since it must respond without destroying trust in the dollar, and for policymakers in savings-surplus countries, who must anticipate a world in which the US demand engine slows sharply. Will they manage to keep the world economy expanding stably? A year or so from now we will have a far better idea of the answer.